Legal Updates

Value and growth: inextricably linked

According to the Federation of Small Businesses, SMEs account for 99.9% of all private sector businesses in the UK, employing 15.6m people (60% of UK private sector employment) and generate £1.8 trillion in annual turnover (47% of UK private sector turnover). It is no wonder that SMEs are a vital part of any economy, disproportionately impacting job creation and economic growth.

Growth, in the context of a firm, has many facets and is a particularly important part of a firm’s identity. At the mature end of the spectrum, publicly listed businesses are traditionally valued by fundamental investors on their ability to generate increasing future earnings. These investors will forecast growth and determine the value of the business by discounting future cashflows to an intrinsic value, yielding an estimate of the business’ value today (this is a simplistic explanation of what is known as discounted cashflow or DCF). In theory, the greater the expected future earnings, the greater the value of the firm today.

At the other end of the spectrum, growth is a fundamental piece for survival. Here, investors will also assess opportunities on the basis of potential growth, though this assessment is conducted in the absence of stable and recurring cashflows, earnings and dividends. Therefore, by their very nature, early stage businesses are illiquid investments (there is no market in which to easily trade securities in a private business) whose success will depend on a number of factors, some of which are simply difficult to express in cold hard numbers. Ultimately, it is the investors’ perception of these factors that will determine the value of a business. In the context of angel investors, these perceptions will likely be shaped by previous experiences. In other words, one investor might perceive the opportunity to have huge growth prospects, perhaps based on their insider’s view of the industry, whilst another investor might have the complete opposite view of the same opportunity. These factors might include perceptions of, amongst others:

Management team

Technology – competitive advantage

Traction in the marketplace

Market size

Future funding rounds

The exchange of cash for equity eventually puts an implicit value on the business. This will have implications for future funding rounds where investors would need to be convinced that the business’ growth trajectory sufficiently warrants an uplift in valuation. As the business grows, traditional methods of valuations such as DCF, comparable transactions and industry multiples begin to become more relevant. The biggest risk of a high initial valuation is that the business doesn’t live up to its growth prospects as perceived by investors, a situation which will force the business into raising a ‘down round’ (a lower valuation than the previous round). This partly results from the maturing nature of the business, additional comparability within the marketplace and further information which the investor can use to hone his or her valuation expectations.

Forbury Investment Network helps early stage technology businesses navigate the fundraising landscape, simultaneously working with a range of high net worth individuals and family offices interested in deploying capital into venture capital as part of their alternative asset class allocation. For further information on Forbury Investment Network, please visit the website here.

Zafar KananiForbury Investment Network

Clarkslegal, specialist Commercial lawyers in London, Reading and throughout the Thames Valley.

For further information about this or any other Commercial matter please contact Clarkslegal's commercial team by email at contact@clarkslegal.com by telephone 020 7539 8000 (London office), 0118 958 5321 (Reading office) or by completing the form on this page.